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Zakat treatment in financial statements of Islamic financial institutions

Rizwan Tajammul, Sr. Manager - Financial Control, NBF

Zakat is a mandatory religious tax paid by Muslims who possess more than a specified minimum level of wealth (Nisab), which is to be disbursed according to Shariah teachings. Zakat mechanism channelizes wealth from prosperous factions of society to needy ones and serves as a stimulus for economic activity. On contrary to conventional income taxes Zakat is levied on savings and if implemented widely across societies, can help in eradicating poverty and achieving purposes of distribution of wealth across society by acting as a deterrent to concentration of wealth in fewer hands.

This article focuses on elaborating the accounting treatment for Zakat in the financial statements of Islamic financial institutions as prescribed by the Financial Accounting Standard-9 (FAS-9) of the Accounting and Auditing Organization for Islamic Financial Institutions (AAOIFI).  

FAS-9 aims at setting out the accounting rules for the treatment related to the determination of Zakat base (the base on which Zakat is to be computed), measurement of items included in Zakat base and disclosure of Zakat in the financial statements of Islamic financial institutions. 

Applicability of Zakat on Islamic financial institutions and treatment

Scenario-1

An Islamic financial institution is obliged to pay Zakat under three situations (1) when the law requires the Islamic financial institutions to satisfy Zakat obligation; (2) when the Islamic financial institutions is required by its charter or bye-laws to satisfy the Zakat obligation; (3) when the general assembly has passed a resolution requiring the Islamic financial institution to satisfy the Zakat obligation.

Treatment:

o    Zakat shall be treated as non-operating expense of the Islamic financial institution and shall be included in determination of net income in income statement.

o    Unpaid Zakat shall be treated as liability and presented in the liabilities in statement of financial position of Islamic financial institutions.

Scenario-2

In the absence of conditions mentioned under Scenario-1, Zakat becomes the responsibility of shareholders and in this case some or all of the shareholders may ask the Islamic financial institution to act as an agent on their behalf in meeting the Zakat obligation relating to their investment in the Islamic financial institution from their share of distributable profits.

Treatment:

o    Zakat in this case to be deducted from distributable profits of shareholders.

o    If there are insufficient distributable profits to meet shareholders’ obligation, the amount paid by the Islamic financial institution shall be recorded as receivables from the respective shareholders.

Determination of Zakat base and Zakat amount

Another important aspect is the measurement and Zakat determination. FAS-9 offers two different methods, however these two approaches yield similar results, provided the items included in the calculation are consistently classified and valued with due consideration given to different valuation basis used in both methods.

The first method is known as net assets based on the following formula:

[Zakat base] = Assets subject to Zakat - (Liabilities that are due to be paid during the year + equity of unrestricted investment accounts + minority interest + equity owned by government + equity owned by endowment funds + equity owned by charities + equity belonging to not-for-profit organizations excluding those that are owned by individuals)

The second method is called the net invested funds based on the following formula:

[Zakat base] = Paid up capital + reserves + provisions not deducted from assets + retained earnings + net income + liabilities those are not due to be paid during the year - (net fixed assets + investments not acquired for trading + accumulated losses)

Zakat amount shall be determined by applying Zakat rate [2.5% for lunar calendar year and 2.5775% for a solar calendar year] on Zakat base calculated using either of the above two methods.

Disclosure requirements

FAS-9 lays out eight disclosure requirements for Islamic financial institutions:

  1. Method used for determination of Zakat base and items included therein.
  2. The rulings of Shariah Supervisory Board of Islamic financial institution on the issues related to Zakat that are not included in FAS-9.
  3. Whether or not the Islamic financial institution in its capacity as holding company pays its share of Zakat obligations in its subsidiaries.
  4. The amount of Zakat that is due from each share, in case where the Islamic financial institutions does not pay Zakat.
  5. The amount of Zakat that is due from the equity of investment account holders.
  6. Whether or not the Islamic financial institution collects and pays Zakat on behalf of investment account holders and other accounts.
  7. The restrictions imposed by the Shariah Supervisory Board of the Islamic financial institution in determining the Zakat base.

The disclosure requirements in Financial Accounting Standard-1 by AAOIFI (FAS-1) also to be observed.

This article was first published in IFN Volume 18 Issue 5 dated the 3rd February 2021.